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Rarely deviating from the index but charging for active management is something that ‘5 to 15% of active investment funds’ are guilty of, according to data published by the European financial watchdog ESMA in February. The regulator reviewed 260 investment funds, after the alarm was raised by Swedish investors.
The ESMA has not published the names of these index huggers – or to use their official name, ‘closet index funds’ – and measures are not likely to be taken against them. Or, at least, not by the ESMA – as it believes that this is a task for the national regulators. Peter Ferket, CIO Equities at Robeco, thinks that much of what the study has exposed are remnants of a bygone era – sleeping funds that have forgotten to wake up to a rapidly changing world.
“The ESMA hasn’t provided a list of names, but many of these closet index funds are likely to date from 15 to 20 years ago, when – certainly in Europe – there were very few passive products on the market. So, these funds contain client assets and there is no natural incentive for asset managers to close them. Basically, I think that this is primarily a legacy of our industry's past. The ESMA’s list won't include many funds that have been launched in the past five years.”
Nevertheless, we still can’t overlook the fact that the providers of these funds could have reduced their costs in the interest of their clients, suggests Ferket. “It’s safe to say that these types of funds are much too expensive now. You have to relate the price of an active product to that of a passive solution. Twenty years ago you might have paid 40 or 50 basis points for a global index tracker; now it’s less than 20. This means you can’t ask people to pay 70 basis points for a closet index fund anymore, like you could twenty years ago.”
It's about fair prices, according to Ferket. “The costs of a passive product form the basis for establishing these. Then there should be a reasonable charge for the alpha that you think your fund can generate. And if the passive solution gets cheaper, of course the price of the active alternative should move accordingly.”
By nature closet index funds deviate too little from the index in order to recoup their higher costs. Cremers and Patajisto (Yale University) reached this conclusion in their study into active share (‘How active is your fund manager?’). Recent research by Morningstar confirms their findings: closet index funds achieve the weakest returns of all active investment fund types. This proves once again that the high costs of these funds are unjustifiable.
Nevertheless, many providers of these products seemed to have overlooked that fact that we have entered the 21st century. While passive solutions were getting cheaper and cheaper, they just rested on their laurels. As a result, they are now much more expensive than passive solutions, even though their structure enables them to generate little or no alpha. “We decided to move further away from the index years ago,” explains Ferket. The Robeco Fund is a good example: a globally invested fund with an active share (a percentage that indicates the absolute level of deviation from the benchmark) of above 80%.
“We were faced with a choice for this fund: lower the costs or allow the fund to deviate further from the benchmark, with higher expected alpha as a result. We chose the latter,” – a decision that according to Ferket was motivated more by the investment philosophy than by commercial interests.
Currently under pressure from dissatisfied investors and regulators, closet index funds seem to be on the path to extinction. People's perception of their added value has vanished like snow before the sun due to the increased popularity of index trackers and ETFs. And they also seem to have played out their roles in this sector. “Initially there were truly active core products; then passive ones appeared too. But we now know that a combination of the two styles – passive for beta and active for alpha – is more effective than a single core fund.
“By combining ETFs with funds that are truly benchmark-agnostic, you can easily adjust your portfolio to achieve the desired level of active share or tracking error,” explains Ferket. “That’s why at Robeco we focus on both our quant products – a better alternative to passive funds – and on high conviction funds.”
According to Ferket, it is very clear that the increased popularity of ETFs has resulted in a different product range at active managers, where active strategies are becoming increasingly close to hedge funds. Ferket also points out that it is becoming increasingly difficult to differentiate between the different styles in terms of the way they operate. “You used to have core funds, passive products and hedge funds. They were three different worlds. Now you have largely passive at the one end of the product range, high conviction funds at the other end and smart beta in the middle.”
Ferket does not see any significant growth potential for smart beta ETFs. “It’s a bit like the situation with hedge funds at the beginning of this century. The best managers start with them and achieve superior returns, but then they become more mainstream, supply increases and average performance deteriorates, while the risk of upsets at individual providers increases.”
But the increased popularity of smart beta indices is raising the bar for active factor funds. “Value funds or low volatility funds are no longer compared with the MSCI World Index, but with the MSCI Value Index or MSCI Min Vol Index. This means you can no longer just get away with harvesting the value or volatility premium.”
This is the new reality – where active fund managers, hounded by competition from the passive market, are being forced to innovate and continuously re-examine and improve their products. It is a world in which the asset management industry regularly sheds its skin, as it is doing now in the case of closet index funds. And everyone benefits from this.